What About Taxes?

Estate planning clients often ask questions about taxes. What will be owed? How are they paid? When are they due? Who must pay them?

There are several taxes that apply in the context of estate planning. The most common of these are income taxes, estate taxes (also known as inheritance or death taxes), and gift taxes.

Income Taxes.

This is likely the area of taxes with which people are most familiar. We are accustomed to paying taxes on our income, so many people simply expect to pay income taxes on inheritances.

Actually, there is some good news here. As a general rule, no income taxes are owed by an heir who receives an inheritance – at least for most types of inheritances. This means that when your uncle leaves you $10,000 in his Will, you will likely not pay a dime to the IRS for that inheritance.

That said, there are notable exceptions to this general rule, such as in the context of IRA earnings. Also, there are limitations to this general rule – for example, the $10,000 your uncle left you might be free of income tax, but the interest earned on the $10,000 after he died is still subject to income taxes.

Estate Taxes.

Federal law requires every decedent’s estate pay a tax to the IRS equal to 40% of the value of the decedent’s estate. 40% is a huge amount, so why don’t we hear more about it? Because most people don’t pay it – legally!

The reason is that the law provides an exemption from the tax if the total value of the estate is less than about $5.5 million (an amount that increases each year). Because almost all estates are less than this amount, this is a tax that does not affect most people.

Further, under current law, if one spouse dies and does not use the entire $5.5 million exemption, the unused portion of their exemption is available to the surviving spouse. Put together, that means that a married couple enjoys a combined exemption amount of nearly $11 million.

There are other exceptions from the estate tax. For example, the inheritance received by the spouse of the decedent is exempt from the estate tax. In addition, all amounts left to charity are exempt.

Florida law, by the way, does not impose any estate taxes, inheritance taxes, or death taxes. Thank you, Florida!

Gift Taxes.

Sometimes clients think to avoid estate taxes by ‘giving it all away’ before they die. Well, the IRS wasn’t born yesterday.

Federal law requires anyone making a gift during their lifetime pay a tax to the IRS equal to 40% of the value of the gift. Note this is the same tax rate as the estate tax.

Here again, 40% is a huge amount. Why don’t we hear more about it? Here again, it is because of the exceptions.

Many clients are familiar with the ‘$10,000 a year’ exception from the gift tax. This refers to a federal law that allows anyone to make gifts to anyone without paying any gift tax, as long as the total value of gifts made by the ‘donor to the donee during the calendar year does not exceed $10,000. Better still, that $10,000 amount has increased over the years to $14,000 under current law.

This means that your uncle could give you $14,000 for your birthday without paying any gift taxes. Because the $14,000 a year exclusion is ‘per person’, your uncle and aunt could each give you $14,000 without paying gift taxes – that’s $28,000 to you. If you are married, your uncle could give you and your spouse $14,000 each and your aunt could give you and your spouse $14,000 each – that’s $56,000 from your aunt and uncle to you and your spouse without any gift taxes.

What if the amount of the gift exceeds the $14,000 exclusion? It is usually still possible to avoid gift taxes, because of the $5.5 million ‘estate tax exemption’. Actually, that $5.5 million exemption applies to both estate taxes and gift taxes. Using the exemption to avoid gift taxes is perfectly legal. When you do so, you reduce dollar for dollar the exemption amount available for your estate.

For example, say your uncle gives you a home worth $500,000. After applying the $14,000 exclusion, there would be $486,000 subject to gift taxes. Rather than paying 40% of $486,000, your uncle may choose to file a report notifying the IRS that he will use $486,000 of his available $5.5 million exemption. That means his estate will have about $5 million of available exemption, rather than $5.5 million.

Like the estate tax, there are exceptions from the gift tax. Marital gifts and charitable gifts are common examples.

Florida law, by the way, also does not impose any gift taxes. Thank you again, Florida!

Planning.

When you put together all of this tax information, there are plenty of opportunities to help individuals plan to avoid tax burdens.

For example, if you have an asset that you believe will appreciate in value, it may make sense to get the asset out of your name so that the appreciation will not be included in your estate. This is the theory underlying many irrevocable trust strategies.

Let’s say your uncle has a vacation home worth $5 million and he believes the home is likely to increase in value in the near future. Uncle could create an irrevocable trust and transfer the home into the trust. Note that this transfer is itself a gift that triggers the federal gift tax. Your uncle can avoid the gift tax by using most of his available $5.5 million exemption. When he dies, the home would be owned by the trust and is not subject to estate taxes in his estate. Even if the home has increased in value to $10 million, his estate will not owe any estate taxes. That’s a great way to remove a lot of value from his taxable estate.

Obviously, there are many details to be addressed in this type of planning. There are also rules for gifts to grandchildren and more remote descendants. The take-away message is that planning is possible.